Nokia's Rope-A-Dope Of Microsoft

Apr.25.14 | About: Microsoft Corporation (MSFT)


In an emulation of Mohammed Ali's “rope-a-dope” strategy, Nokia has unloaded its unprofitable mobile handset business on Microsoft.

Microsoft refrained from including the impact of the Nokia acquisition in next quarter's guidance, admitting that they don't know what it will be.

Now Microsoft must do what Nokia was unable to do: make its handset business profitable.

During Thursday's earnings conference call, it came out that Microsoft's (NASDAQ:MSFT) guidance for next quarter wouldn't include the impact of the Nokia (NYSE:NOK) purchase. Why? Because Microsoft's financial people won't have the access they need to assess the impact until the deal closes on 4/25. Hearing that, I could only shake my head in wonderment. I consider Microsoft to have the most business savvy of the big three mobile computing players including Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) (NASDAQ:GOOGL). How did Microsoft's management let themselves get roped into this?

X Factor

Highlighting the lack of visibility into Nokia's inner financial workings, Nokia won't report results for calendar Q1 2014 until April 29, after the deal closes. In 2013 Q4, Nokia reported results for the Devices and Services division as Discontinued Operations with revenue of $3.64 billion and an operating loss of $273.7 million.

What started out as a not particularly attractive deal has only become worse over time. For Microsoft's $7.52 billion it gets a money losing mobile and smartphone business and licensing of Nokia patents, but not ownership of the patents. At least Google (GOOG) got ownership of a respectable patent portfolio for the $12.5 billion it paid for Motorola, which it didn't sell when it unloaded Motorola on Lenovo (OTC: OTCPK:LNVGF).

Microsoft was to have acquired Nokia's world-wide mobile phone manufacturing facilities, but the terms have changed. Microsoft won't be getting the Chennai, India, facility, which Nokia calls "one of our biggest" or its Masan, South Korea, facility, which Nokia calls "state of the art" for smartphone manufacturing.

Perhaps by way of compensation, a small part of Nokia's Advanced Technologies division, located in China, will be transferred to Microsoft.

Under terms of the agreement, Nokia is only precluded from making and selling its own Nokia brand phones for a period of two years. That's barely enough time to design a new smartphone and get it into production. Does anybody see where this could go? I'll give you a hint: Nokia X.

When X, Nokia's thinly veiled Android smartphone, was shown at Mobile World Congress this year, Microsoft apologists contorted themselves mightily to find a way where this would work out favorably for Microsoft. I received numerous comments to the effect that Microsoft had to know and approve of the move. Nokia X would be popular in emerging markets and provide a gateway to Windows Phone upgrades, it was claimed. As an emerging market strategy for Windows Phone, Nokia X was just barely plausible, but probable? I think not, but we'll soon know for certain.

I get that Microsoft wants to be an integrated devices and services company in the Apple vein, but even Apple doesn't try to build its own smartphones. What expertise does Microsoft have in global supply chain management, mobile phone manufacturing, or smartphone design and engineering that will allow it to reverse the fortunes of Nokia's handset business. Answer: it doesn't have any.

Speaking of handsets, the worst part of the deal is that Microsoft had to take Nokia's mobile phone business. It was a package deal. We're told that Microsoft will leverage the mobile phone business and user base into sales of Windows Phone, a sort of gateway drug theory of smartphone recruitment. But it hasn't worked for Nokia and probably won't for Microsoft.

Right the First Time

The Microsoft Board's initial reaction to Steve Ballmer's proposal to buy Nokia's phone business was probably the right one: they thought it was a bad idea. As reported by Bloomberg, Bill Gates and several other board members opposed the plan back in June 2013. Nadella is also reported to have opposed the deal initially. Ballmer is reported to have shouted down opposition, but the argument is thought to have led to his early retirement, announced only two months later.

The Bloomberg report raises the question of why the Microsoft board, if they really felt Ballmer was out of line, didn't overturn the Nokia deal after easing him out. But once the purchase was announced in September, Microsoft was more or less locked in. The purchase agreement called for Microsoft paying a $750 million "Termination Fee" if Microsoft bailed out. But I'm not sure that even the termination fee would have been enough deterrence on its own. This is where Nokia X may have been intended as an additional disincentive, as I discussed in "Nokia Sends Microsoft a Message." The agreement also allowed Nokia to cancel its existing agreement with Microsoft to use the Windows Phone OS in the event of termination by Microsoft.

Bemused Leadership

I get the impression that Satya Nadella is an intelligent and capable executive as well as a knowledgeable software engineer who really understands cloud services. But if he has any idea how Microsoft is going to turn Windows Phone into a profitable business, he isn't letting on. He tends to speak only in vague generalities and catchy sound bites: "Our industry respects innovation, not tradition."

I haven't heard any pronouncement from anyone at Microsoft pertaining to concrete steps that they are taking in Windows Phone to make Microsoft Mobile products profitable. The most definitive statement I've heard is the decision to offer Windows Phone and RT to OEMs free for screen sizes under 9 inches.

Well, of course, Microsoft had to give Windows phone away to OEMs after buying Nokia. Otherwise, there would have been a mass exodus of Microsoft's Windows Phone partners. Bad enough having to compete with Microsoft's in-house devices, let alone having to pay royalties to Microsoft for Windows Phone OS. This only points out the perils of Microsoft's "have your cake and eat it too" Windows device strategy.

When We'll Know

Investors will have to wait until the July earnings report to find out the extent of the damage from Nokia. Certainly, the $273 million Nokia's Devices and Services division lost in calendar 2013 Q4 could be absorbed without much difficulty by the Microsoft Devices and Consumers segment, which had operating income of $2.37 billion in the latest quarter. And there will be the usual restructuring charges and plant closures as Microsoft struggles to achieve mobile and smartphone profitability. D&C won't start losing money because of the Nokia purchase, but Nokia will weigh on D&C operating income for the next year at least.

Can Microsoft make the Nokia purchase work? It's certainly possible, but I keep coming back to the fact that Microsoft really didn't need to take this on right now. Nadella and his management team have enough on their plates already.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.